Shareholders Agreements – Are They Desirable? by Tony Mead

I am often asked, especially by entrepreneurial clients embarking on a start-up venture where the budget for legal services can be limited whether it is really necessary to have a shareholders agreement or whether they can rely upon the Model Articles under the Companies Act 2006.

My response is invariably an emphatic “Yes!” Deadlock companies i.e. those with equal shareholdings require unanimous consent to resolve issues, the only other option being to apply to the court for winding up which is both expensive and uncertain and minority shareholders, in the absence of a shareholders agreement containing protective provisions, can find themselves in a vulnerable position from which they will find it difficult to exit.

Why a shareholders agreement?

• A well-drafted shareholders agreement focuses minds as to what is required for a business to operate in a viable way. It provides a framework for key issues including the provision of capital and loans; rewards; management structure; exit strategies; and dispute resolution. If these matters are not given adequate attention shareholders can quickly find themselves in dispute. A shareholders agreement also gives flexibility as it is easier to amend its terms than it is to vary the articles of association as the business develops.
• The articles should not conflict with the shareholders agreement and the two should be reviewed together. The provisions in either document are often interchangeable but careful consideration is required. The articles are visible to anyone who searches a company’s file at Companies House, but this is not generally the case with a shareholders agreement which can be filed but seldom is.
• Provisions in the articles are less easy to enforce than those in a shareholders agreement. The articles operate as a contract between the members and the company whereas a shareholders agreement is a contract between each of the members. Like any other contract to be valid and enforceable it requires consideration or should be executed as a deed. The company can be a party to a shareholders agreement so members can owe obligations to the company as well as to each other but care is needed to ensure that members do not become subject to personal unlimited liability and that the company is not restricted by the agreement from exercising its statutory powers which it cannot do.

What matters should be covered in a shareholders agreement?

• The provision of working capital and whether this will be by way of shareholder loans and, if so, on what terms. Usually, investors subscribe for shares which are issued pro rata to the amount invested. Capital can be difficult to withdraw so a loan is generally preferable although banks and other investors will often expect to see a level of fixed capital on the balance sheet for stability.
• The parties should consider what effect the repayment of loans will have on the business. Most shareholders will not wish to make a commitment for unlimited future funding and it is, therefore, prudent to have the matter covered in advance in a shareholders agreement. If the company needs more funding than the shareholders can provide it may have to source it externally through term loans, asset finance or factoring/discounting. If so, it is likely that a floating charge will be required by the lender and possibly guarantees from the shareholders. This can also be provided for in the shareholders agreement.

What about salaries and dividends?

• The amount and timing of the benefits which shareholders will receive from the company will be subject to affordability and should be dealt with in the shareholders agreement to avoid fundamental disagreement. Whether the working directors are to receive a salary and the company pay dividends or whether milestones should be reached are matters to be discussed and agreed.

How will shareholders get their money back?

• Often overlooked is what will happen to the shares of someone who leaves or dies. The remaining shareholders will usually want a right of first refusal to prevent outsiders from becoming involved in the company’s affairs so pre-emption rights are often incorporated.
• Share valuations can be difficult and the surviving shareholders may not always have funds available to make a purchase. The valuation method needs to be agreed. A decision will be needed as to whether it should it be on an open market basis, assumed to be between a willing buyer and seller with the business valued as a going concern and whether the size of the shareholding should affect its valuation as substantial discounts typically apply to a minority shareholding which has no control or veto rights.
• Selling their shares represents the best chance of a member achieving an exit and recovering his or her investment but, in reality, the chances of selling a minority stake in a small company on the open market is very small, so a sale of the entire share capital is far more likely, but in the absence of agreement to the contrary this will have to be agreed unanimously or by at least 90% of the members.
• 979 of the Companies Act 2006 provides that when 90% of the shareholders have agreed to sell, the remaining shares can be acquired compulsorily but the procedure is lengthy and difficult. Drag and tag along rights (which contractually bind minority shareholders to sell and give them the right to be included in a sale by the majority) can be included in the articles or, preferably, in a shareholders agreement to ease this procedure but it should be remembered that these provisions have never been tested before the English courts and there is some doubt as to their validity notwithstanding their commonplace use in shareholder agreements. The process of mopping up fragment shareholderscan be uncertain and cause delay which is off-putting to a would-be buyer of all of the shares.

 Employees who are also shareholders

• Generally it is a requirement that shares held by employees will be bought back or handed back to the company on departure. A shareholders agreement will often differentiate between “good” and “bad” leavers in terms of the level of compensation, with bad leavers receiving less, if anything, for their shares. Death and retirement at normal retirement age are usually treated as good reasons for leaving but retirement due to ill health can be more contentious.
• Non-compete clauses are typically included in shareholders agreements for a variety of reasons. These are covenants in restraint of trade and, as such, are regarded by English law as being contrary to public policy, save to the extent that they are necessary to protect legitimate business interests. Many types of restriction are common in employment contracts and there is much case law on what is reasonable and, therefore, enforceable. Non-compete clauses in shareholders agreements are construed less restrictively so are generally more effective than those in employment agreements.

The above pointers illustrate the pitfalls that can await the unwary entrepreneur. It is, therefore, recommended that, before embarking on any new business venture advice from an experienced corporate lawyer be sought.